Eurobonds? Be Careful What You Wish For!

"Many of the implications of Stability Bonds go well beyond the technical domain and involve issues relating to national sovereignty and the process of economic and political integration."

With this introduction, the European Commission presented various options eurozone countries to issue common bonds, known as Eurobonds, which the Commission, being politically correct, has called "Stability Bonds”. This is a way to avoid annoying the opponents of the idea, especially Germany, as the expression ‘to turn the EU from a debt union into a stability union’ belongs to Angela Merkel. While presenting the Green Paper on the Stability Bonds European Commission President Jose Manuel Barroso was genuinely angered by a journalist's question what he aimed with promoting the idea of Eurobonds, while being aware that Germany was opposed. Germans do not oppose the principle, but only the timing, Barroso said . According to him, "the idea makes its way" and that’s why the Commission subjected it to a broad public debate.

The idea of Eurobonds is not new, but it has never gathered enough supporters to be, if not realised, at least seriously discussed. Last year, the prime minister of Luxembourg and president of the Eurogroup, Jean-Claude Juncker, and Italian Finance Minister Giulio Tremonti blew the dust off the Eurobonds and launched it as an effective means of addressing the debt crisis. The idea enjoys warm support by the European Parliament - one of its most vocal supporters is liberal leader Guy Verhofstadt. It was namely the Parliament that had pressed the Commission to propose (or at least to examine) the introduction of Eurobonds as part of the deal on the adoption of the EU economic governance package.

Now, as Commission President Jose Manuel Barroso repeatedly stressed, the Commission has fulfilled its commitment and presented the so called Green Paper, describing three possible approaches to the Eurobonds. All this long introduction explains why the Commission presented a very distant and even sceptical exploration of possible models, while recalling repeatedly the message I started with: Think not only about the benefits, but keep in mind the necessary "sacrifices" which you must make. It also stresses that whatever option is chosen, it "would have to be accompanied by a substantially reinforced fiscal surveillance and policy coordination as an essential counterpart, so as to avoid moral hazard." And the moral hazard lies in the fact that without the pressure of financial markets the countries will settle down, they will once again give rein to public finances and postpone reform.

The three main options proposed by the Commission suggest varying degrees of sharing debt, risks and benefits. The first possible approach is that of full-bodied Eurobonds – i.e. “full substitution of Stability Bond issuance for national issuance, with joint and several guarantees”. This is the ideal option when all the possible benefits will be achieved with zero risk. Countries with higher borrowing costs will have access to cheaper financing, and the Commission describes a number of other indirect benefits for the euro area as a whole. The problem is that this option will take time because it requires "a significant further step in economic, financial and political integration," which goes through Treaty changes. This option creates the greatest moral hazard, so it is important to have all guarantees that member states will observe budgetary discipline, will improve competitiveness and reduce macroeconomic imbalances, the Commission specifies.

The second option is the so called "Blue-red" approach: “partial substitution of national issuance with Stability Bond issuance with joint and several guarantees”. A debt threshold should be defined (for instance 60% of GDP, as recorded in the Stability and Growth Pact) to which it can be shared - this is the ‘blue’ zone. The ‘red’ zone lies above this limit and shows the debt that will remain in national bonds. This will encourage member states to reduce the expensive ‘red’ debt and will reduce the moral hazard arising from the shared responsibility for the ‘blue’ debt. The key issue in this approach is precisely the definition of the threshold that should not be too low so the common bonds to be effective, nor too high so to increase the moral hazard. There is also an option for a flexible threshold, which varies according to how a given Member State implements its commitments - better implementation gives it the right to issue more ‘blue’ debt and vice versa.

A variation of this option is the proposal of the German Council of Economic Experts for a common debt redemption fund. The idea is the debt of countries exceeding the limit of 60% to be united in a common fund with joint guarantees, that would issue virtually risk-free bonds. Any country wishing to benefit from the fund should sign a consolidation programme, committing to buy back its debt within 20-25 years. In addition, countries should increase a national tax (VAT and/or an income tax) and to pay the additional revenue directly to the fund. There is also an explicit clarification that the fund should be a temporary means (including because of the provisions of the German constitution) which to give the countries time to conduct the necessary consolidation and reform, without being subjected to extreme market pressure.

The third approach is partial replacement of national debt by common bonds with pro-rata guarantees of eurozone member states. This approach brings the least moral hazard, because each country will be liable for its share in the common debt but the benefits will also be far smaller, compared to the full-bodied Eurobonds. The possibility for countries with high borrowing costs to get a reduction due to these with lower borrowing costs is also far less than in the ideal option. But implementation of this model is much faster and can be done under the current legislation. Presented this way, it would have more symbolic significance as a signal to markets that Europe is ready to accept the idea of debt sharing. The Commission specifies that, if agreed, such partial version could be chosen, accompanied by a concrete roadmap for transition to full-bodied Eurobonds.

With all options, however, national ceilings for debt issuance should be defined in advance. This is another reason the "Stability Bonds" to be introduced only provided there is an increased coordination of budgetary policies. The system needs to provide guarantees that all countries will abide by the rules, as well as appropriate incentives. At the same time, it is possible to put macroeconomic and fiscal conditions for entering the system of Stability Bonds, for example a country may be denied access if it does not comply with the Stability and Growth Pact (SGP). And once having entered the system, the countries may be sanctioned for non-compliance with additional guarantees or higher interest rates. A number of additional issues need to be clarified, such as whether to create a European debt agency to manage the process and how it will interact in the European Stability Mechanism.

Introducing the Green Paper, the European Commission launched public consultations, which will continue until 8 January 2012. Then, in mid-February, the Commission will come forward with views on how to continue the process. There have already been comments that even the German resistance against Eurobonds is softening. There are reasons for that since, together with the Green Paper on common bonds, the Commission also presented two new proposals to strengthen economic governance in the euro area. Although they seem revolutionary indeed in terms of the degree of institutional control over national budgets, they are only the beginning of this "substantially reinforced fiscal surveillance and policy coordination", set by the Commission as a precondition for Eurobonds. And there is no other way because, although the idea seems attractive as a quick and easy remedy for the debt crisis, it poses a long-term risk the real problems once again to be swept under the carpet, until the next crisis.